There are many aspects involved in choosing the appropriate stocks to invest in. I assume that most of the visitors to this site choose their own investments, but for those of you that avoid stock picking and use investment advisors be sure that your advisor considers all of these aspects. If he or she does not, find a new one now. These aspects to consider in picking stocks include your risk tolerance, time horizon, tax status and investing objectives (ie income vs. capital growth) as well as current market conditions. The goal of investing is of course to maximize returns while taking these aspects into consideration. So before we take a look at how to pick individual stocks we must first consider and realize what we want out of our investments.
Risk Tolerance
Risk tolerance is a measure of the volatility one is willing to accept. In other words a very risk tolerant individual is willing to accept high volatility and therefore a likely chance they will lose money on their investment. Individuals are rewarded for accepting higher risk with potentially higher gains. Someone that can afford to lose the money they are investing and those that can be patient with their investments are more risk tolerant. These individuals are looking for the highest potential returns which are, as the history of the stock market teaches us, within small cap stocks. They would also be more likely to invest in risky stocks such as IPOs and those of companies in financial trouble and diversification would be less of a concern. Less risk tolerant investors would be better suited to investing in large cap stocks(blue-chips) and would want to make sure to strongly diversify their investments. Extremely risk adverse (ie very low risk tolerant) investors would most likely shy away from stocks all together in favor of more secure investments such as Treasury securities, CDs, and Annuities.
Time Horizon
The time horizon or simply the time that you have available before you need to liquadate investments is a very important factor in investing. For the most part this comes down to your age and what you are looking to do with the proceeds of investments. A young person looking to start a retirement account has a long time horizon, while a married couple looking to save up for a down payment on a new home has a much shorter time horizon. The longer your time horizon is, the more risk tolerant you can be. This is simply because an individual with a long time horizon can look past the short term ups and downs of his investments and wait out the eventual long term gains, while someone with a short time horizon will need to liquadate soon and therefore cannot accept as much volatility risk. Someone with a short and set time horizon (ie needs to liquadate to make a payment in 1 year) would most likely shy away from stocks and the volatility risk involved. CDs and Treasury bills would be more appropriate in this situation.
Tax Status
Your tax status is an often overlooked aspect to investing in stocks, until April 15th comes around. It should be considered when choosing what stocks to invest in simply because someone in a higher tax bracket will pay much higher taxes on short term gains(taxed as ordinary income) as opposed to long term gains(taxed as capital gains). Therefore it would be less beneficial for an individual in a high tax bracket to invest in a stock that is expected to see a short term pop as opposed to an individual in a low tax bracket. Tax status is also important when deciding whether it is beneficial to choose a stock that pays high dividends or a growth stock that retains most of its earnings.
Investing Objectives
Your investing objective is simply what you want from your investments and when you need the returns. The major factor here is current income vs. growth. An investor that is retired and relys on investments to live must receive current income from these investments. Therefore stocks that pay high dividends would be attractive. Utilities are usually the highest divident paying stocks. Someone that is saving for retirement or for any other future need of funds would want to invest in growth stocks. Current income is not important to these investors while appreciation of capital is.
Current Market Conditions
Lastly is the current market condition, ie are we in a period of expansion or recession, are certain sectors likely to outperform others etc. During times of expansion, growth stocks and small cap stocks tend to outperform all other investments. While during recessions the same stocks tend to drop more than others. There are also investments that perform better during periods of recession. These are called counter-cyclical stocks. Cyclical stocks are ones that tend to move up and down in the same direction as the economy while counter-cyclical stocks more in the opposite direction.
Now once you have determined what investment types, ie small caps, large caps, certain sectors etc. are suitable for you, it is time to figure out which individual stocks within these categories you should put your money into. Often investors simply punch some factors into a stock screener and go ahead and invest in whatever the screen feeds back to them. The problem with this is that stock screeners miss the single most important factor in determining how well a stock will perform. That is the recent news released by the company and by others about the company. Lets say that stock XYZ releases after the close that it just lost one of its main clients and an outside news company also releases that some outside world event will negatively affect XYZ's industry. An investor that uses a stock screener that night will not be taking these factors into effect. Also the stock is likely to drop in price over the next few days which means that statistics like the P/E ratio, P/S ratio etc. will look even more attractive even though the companies expected returns should obviously drop. Even projected earnings and ratios will look more attractive until revisions are made based on the recent news. The lesson is that an investor that does not keep up on the recent conditions and news related to a stock is missing a key factor in the returns he can expect to see by investing in said stock. So while stock screeners can be used to compare different indicators and statistics of stocks, they should not be used blindly, and investors should always do their own research into each company they invest in. Now lets look at the two main techniques used by investors to analyze stocks. These are fundamental analysis and technical analysis.
Fundamental Analysis takes into consideration the past, current and expected future financial condition of the underlying company. Some of the more popular indicators used by fundamental analysis are P/E ratio, P/S ratio, P/Book ratio, PEG ratio and earnings growth. The P/E ratio is calculated by dividing the current market price of the stock by the earnings per share. The earnings per share can based on current earnings for a current P/E ratio, or projected future earnings for a projected P/E ratio. In much the same way the P/S ratio is calculated by dividing the current market value by sales($) per share. The current P/E and P/S ratios are often compared to historical levels for stocks in order to determine whether or not the current market price is cheap or not. In other words if the current P/E and P/S ratios are much lower for a certain stock than they have been in the past then the stock would be considered to be selling cheaply. These ratios as well as the P/Book ratio can not be compared for all stocks as certain sectors will trade at much higher ratios than others. The P/Book ratio is calculated by dividing the current market value by the book value of the stock. The book value takes into consideration the stockholder's equity which can be found on the balance sheet of the underlying company. I won't go into this any further at this time. The PEG ratio is calculated by dividing the P/E ratio by the earnings growth rate of a company. Unlike the other ratios mentioned the PEG ratios can be compared across sectors. The earnings growth is an indication of how well a company is expanding and becoming more efficient.
Technical Analysis takes into account the past history of the stock's price. Technical Analysis is often referred to as chart reading. Certain formations in charts are considered to be buy or sell triggers which are then acted upon by technical analysts. Another tool used by technical analysts is moving averages. A moving average is simply a chart that is drawn using the average price of the stock for a certain period instead of the price at points in time. Simple price charts are drawn by plotting the price of the stock at certain points in time. Different intervals can be used for each point but the interval remains constant. In other words they can be the closing price of each day or the closing price of each week. Moving averages on the other hand, plot points based on the average price over a period of time. For example a point on a 60-day moving average chart would be the average closing price over the prior 60 days. Each point would be calculated in this way to draw the chart. On a simple chart an increase over the previous day's price would show a move up on the chart, while a move up on a moving average would mean that the price increased over the average price for the previous 60 days. This means that the curve will take longer to move up or down based on sudden changes in price. The longer the moving average is (ie the higher the # days) the longer it will take for a price change to be reflected. Technical analysts often compare the simple price chart to moving averages and certain moving averages to others to determine the potential returns on stocks. In other words the simple price chart crossing over a moving average would be construed as either a buy or sell trigger, and the amount that the current price is above or below a moving average could be considered an indication of the stocks future movement.
Now you might be wondering how I choose the stocks that I am delivering to investors on this website and through the stock picking newsletter. First of all let me say that I am not going to give out exactly how I do choose stocks since this would eliminate my usefullness to you. However, I will tell you that I use mostly fundamental analysis. The main reason is that like stock screeners, technical analysis often misses the recent activities and news related to a company and its stock. Also technical analysis is mostly used for short term investing and I base my picks on potential long term gains. Once again I would like to stress to all of you that you should do your own research into these stocks. The stock picks that I provide to you should not be invested in without solid research done by you. Good luck with all of your investments.
